Where is the Inflation?


fish and netFor years I have been expecting a surge in inflation.  After all, how is it possible that the Fed can be creating so much new high-powered money without a jump in prices?  Surely those who are familiar with the quantity theory of money share my puzzlement over the relatively stable Consumer Price Index (CPI). 

In trying to understand the absence of rising prices I have thought a lot about fiat money and the process by which it enters into circulation.  After a lot of searching and racking my brain I think I’ve found the inflation.

Low CPI inflation is in part a consequence of our broken banking system, as detailed in the January 22 blog.  Because banks are reluctant to make loans, the rate of growth in high-powered money has greatly exceeded the growth rate in M-1. 

But despite our broken banking system, M-1 is still growing pretty darn fast.  For the six months ended December 31 M-1 has been growing at an annual rate of 10 percent, which compares to an annual CPI inflation rate of only about 1.5 percent.  So, where is the money going?  Where is the inflation?

 Recall that the CPI measures inflation in the prices of consumer goods—capital goods are not included.  If the price of an existing factory doubles, that doesn’t show up anywhere in the CPI.  Nor do rising stock and bond prices. And that is where the inflation has occurred, as will be described below.

Perhaps it is useful to visualize an island economy where there are two goods, a consumption good (fish) and a capital good (fishing net).  In the absence of fiat money there would arise some equilibrium price of a net in terms of fish—it might be 20 fish per net.  If a net is expected to catch, say, 30 fish during its five-year economic life, an investor might reasonably be willing to give up 20 fish today in exchange for one.  Of course, no rational investor would  be willing to give up 32 fish now in exchange for a net that is only going to harvest 30 fish in the future—in that case the price of capital is simply too high.      

Continuing with the illustration, let’s now suppose that fiat currency and a central bank emerge on the island.  The central bank prints up money at a rate it deems to be appropriate.  In order to get the new money into circulation the island’s central bank needs to buy something—it can buy fish and/or nets.  Obviously, the terms of trade between fish and nets will be affected by the central bank’s decision as to which it buys.  If the central bank is determined to rapidly print new money and introduce it into the economy entirely by purchasing nets, then initially the price of nets (capital goods) will soar relative to fish (consumption goods).  Depending upon how feverishly the central bank is printing the money and buying up nets it becomes entirely possible that the fiat-currency price of a net will be 40 times the fiat currency price of a fish, even when the net is only capable of catching 30 fish over its economic life.   The central bank in this example is not particularly worried about making a smart investment—its only goal is to get money out there, and fast!

Presently the Federal Reserve is introducing new money at a rate of $75 billion per month.  The money enters the economy through open market operations where the Fed purchases government bonds and mortgage backed securities from hedge funds, mutual funds, investment banks and so forth.  Obviously an initial impact may be to enrich the sellers of the securities the Fed is buying up. But more significantly for the economy as a whole the affect is to drive up bond prices well beyond what would otherwise make sense. 

So that’s why bond prices are so high and interest rates are so low. However, the story doesn’t end there.  The Fed’s intrusion into the market with a flood of fiat money has also impacted the stock market.  Of course, the Fed doesn’t print up money to buy common stocks.  So why have stock prices inflated?  I believe this is easily understood when we consider who is selling all those bonds to the Fed.

Large financial institutions, hedge funds, and well-heeled investors who own bonds are rewarded when the Fed prints up new fiat money and buys some of their bonds for ballooned-up prices.  But upon selling their bonds to the Fed the financial institution now finds itself invested in cash—an undesirable investment in a world where cash is being enthusiastically created by the central bank.  Where do large investors then go in search for a better return?   The answer is to stocks, and thus we see inflation appear in stock prices as well. 

Have we reached the point where the price of capital goods exceeds the value of the future earnings the capital will be able to produce?  (Is the fishing net now selling for 40 fish when it is only capable of catching 30 over its useful life?)  Certainly the operation of the central bank the past several years has pushed us in that direction.  To cite one piece of evidence, The Wall Street Journal reported a P/E ratio of 86 for the Russell 2000  as of January 17, 2014 (http://online.wsj.com/mdc/public/page/2_3021-peyield.html). So, this is where all the money is going, and where the inflation has first surfaced.

Ultimately markets converge towards rationality, and the relative prices of consumer goods and capital goods will make sense. This might happen with falling security prices or with rising prices for consumer goods.  With all the new money sloshing around, I’m still expecting the latter.

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  1. Eamonn said:

    Inflation can be seen in the prices of things where credit is the main factor in buying, and where no collateral is required or where the collateral does not produce an income stream. Thus inflation has surged in college tuitions, house prices, car prices and TWTR stock but at the same time, those prices are fragile and, for various reasons, the federal government is the main if not sole issuer of college loans and mortgages. There is a good reason why the private sector* is reluctant to deal in those markets, for without the government, nobody would have a mortgage or attend college, at least not at anything like the current prices or rates of participation. This is what I call ponzi finance.

    In the rest of the economy for someone to make a loan, there must be at least a possibility of being repaid, so the cash flow is a primary factor in finance. In the production of any good or service, energy is required in order for entropy to be reversed. This is the 2nd law of thermodynamics in a nutshell: for entropy to be reversed, it must increase somewhere else, and energy is required to transfer entropy. There are however a few cases where this is not true, and an increase in entropy has monetary value which include hiring a hitman, rap music, and modern art, but in every other case cash only changes hands for a localized decrease in entropy like mowing a lawn, cleaning a house, and all manufactured goods. But all require energy! What happens when the energy starts to run out? The basis for new credit runs out as well.

    Imagine if tomorrow unlimited free energy was discovered like manna from heaven. I don’t doubt for a second we would nearly immediately have a surge in general inflation and economic activity take off like a rocket. The reserves or high powered money is a necessary, but not sufficient, condition for inflation, and for non-ponzi credit to cause it. Literal gasoline (or fossil fuel) is the match in the matches and gasoline analogy that Brian made. Even with a sluggish economy, crude prices are persistently above $100. And in this economy, crude prices factor into everything, whether production, transportation or both. And the increased prices for necessities, i.e. food and transportation, naturally crowd out spending on luxuries. I have frequently heard it argued that retailers like Sears and JC Penney** are struggling because of buying online from the Brown Truck Store (UPS) or management’s incompetence but I think the causes are deeper and that is because more of an average household’s budget increasingly goes to energy, which at the end of the day goes into the atmosphere as waste products and waste heat, nothing that lasts. Taken to the other extreme, imagine if crude oil were not available at any price. What would the economy look like then?

    In conclusion, in my humble non-economist mind, if inflation occurs it will be through ponzi finance, not traditional lending, unless unlimited free energy is discovered.

    * Stocks are bought on margin where the risk falls mainly on the speculator, not the lender.
    ** Anecdotally, several local restaurants in business for decades have recently closed their doors.

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